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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Monday, August 25, 2008

Understanding Valuation Multiples with Respect to Cash

A common mistake I see people make refers to how a firm’s cash stockpile is treated in the valuation process. Specifically, Investors err when they subtract cash from market value before calculating an earnings multiple that includes interest income. P/E multiples are calculated using EPS, or net income per share. This figure includes interest income that is generated from a firm’s cash investments. It’s incorrect to make assertions regarding P/E ratios based on cash/share values. For instance, $100 share price & $5 EPS, and has $20 cash/share, the firm’s P/E is 20x. End of story. No adjustments are to be made, nor should the $20 cash/share have any bearing/relevancy in that scenario. It’s true and only P/E multiple is 20x. The common mistake is to adjust the share price by the cash/share and then divide earnings. Hence: 100-20= 80/5 = 16x. If the $20 cash/share earns 5%, then it contributes $1 to EPS. If cash were eliminated from the calculation, it needs to be done on both sides. EPS would then be $4 not $5, and $80/$4 is 20x. Multiple doesn’t change because the value of the cash was captured in the share price as well as the EPS. Therefore, cash/share doesn’t have any effect on P/E multiples and shouldn’t be part of P/E analysis.


Let’s take Apple (nasd:AAPL) for example: Price =  $172.55, Cash/Share = $23.45, FY09 EPS Estimate = $6.06. The forward P/E is 28.5x. The  incorrect computation is to subtract cash from the share price before dividing by expected EPS: $172.55 - $23.45= $149.10 / $6.06 = 24.6x. The rationale people give for making this mistake is that one share of Apple represents $23.45 of cash and a business that generates $6.06 in EPS, thus an investor can purchase the earnings stream for $149.10.

Here’s the issue- the cash balance contributes to earnings in the way of interest income. Without the cash stockpile, EPS would be lower. One must not assume that Apple’s FY09 EPS will be $6.06 without interest income, thus a higher multiple should not be assigned on the basis of its high cash/share. In FY07, Apple earned $647 million in interest from its cash holdings, which totaled $15.4 billion at year-end. In per-share terms, interest income contributed roughly 51 cents to Apple’s reported FY07 EPS of $3.93. Apple’s P/E multiple based on FY07 EPS is 43.9x. Without interest income, EPS falls from $3.93 to $3.42, and subtracting cash from share price, Apple’s historical P/E is 43.6x. That’s roughly the same as the multiple calculated with cash included in both price and EPS. The common mistake is not subtracting out interest income from EPS while taking cash out of the share price. Therefore, it’s incorrect to subtract cash from one figure without taking it out from the other figure as well.

Since P/E ratios represent income that includes interest income, the conversation of cash/share is inappropriate, as it has no bearing on value, nor multiples in that regard. It’s incorrect to assert that a firm’s P/E multiple is actually lower because it has a relatively high cash/share, and that one should consider cash/share in tandem with P/E ratio. The cash/share is accounted for in the P/E ratio because it’s a part of the “E” or earnings, which includes interest income. The cash balance is the present value of future interest income, thus the two are the same.


In instances where EBIT or EBITDA figure (Earnings before Interest, Taxes, Depreciation, Amortization) is used in a price multiple, then cash holdings should be considered since interest income (expense) is not captured. Thus, a P/EBITDA multiple makes an incorrect comparison since cash & debt aren’t included in the value of the denominator but are in the share price, or market value of the equity. To properly compare EBITDA, one should use enterprise value, or EV, in place of share price, or P. EV is the market value of the equity plus value of debt minus cash. Therefore, the multiple becomes EV/EBITDA. Cash holdings are excluded from the value figure, numerator, as well as excluded from earnings stream, EBITDA, in the denominator. 


To calculate multiples correctly, one shouldn’t include components in the numerator without also including in the denominator. If one is computing P/E multiple, then cash/debt needs to be ignored because those values are captured in the EPS. If one is computing EBITDA based multiples, then EV instead of P, is the correct input for the numerator. Since EBITDA doesn’t account for interest income/expense, then it would be much higher for a debt-laden firm. If share price, P, were used instead of EV, then the numerator would be too low resulting in too low of a multiple. Adding debt to arrive at EV, increases the numerator to coincide with the exclusion of interest expense increasing the denominator as well. 

Tuesday, August 19, 2008

Apple vs Google: Detailed Comparison

I have been coming across many comparisons between Apple (nasd: AAPL) and Google (nasd: GOOG) lately, especially given that Apple’s market cap surpassed Google’s last week. A recent example is Felix Salmon, who doesn’t think Apple should be worth more than Google as he argues in “Apple vs Google.” Mark Krieger compares Apple to Google and concludes Apple’s valuation is lofty and due for a pullback. The authors do make some great, valid points, yet their conclusion is ultimately flawed due to the failure of comparing on a free cash flow basis. Cash flow, not accounting earnings, determines an asset’s value. For the matter of an Apple-Google comparison, there are significant differences in free cash flow production, hence return on invested capital (ROIC).

I present the following analysis of the similarities/differences between the two firms.

The primary issue I take, is the common fallacy of valuation comparisons using price-earnings multiples. Last month, I wrote a rather detailed analysis about the disconnect between Apple’s reported earnings and its cash flow (Investors Overlooking Cash Earnings). This gap will widen as iPhone sales accelerate. The iPhone accounting treatment calls for its revenue to be recognized over 8 quarters, yet Apple receives cash in the full sale amount when they occur. A very astute Apple analyst, Andy Zaky, whom I highly respect, echoed my viewpoint in his recent commentary- “Apple Should Be Valued on a P/FCF Basis.” Zaky reported that many are making the mistake of comparing Apple to Google based on reported earnings multiples, which he states is inappropriate. Zaky couldn’t be more correct in that assertion. Andy Zaky and myself are not alone in thinking that the P/E as a value metric for Apple is misguided. Stephen Coleman of Daedalus Capital wrote “The price earnings multiple (P/E) is an increasingly useless metric when valuing Apple’s stock price. The reason why is that Apple now uses subscription accounting”

In summary, Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending levels that affect free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Price Multiple Comparisons- Apple vs Google:

The first table illustrates the differences between P/E and P/FCF based comparisons. First, let’s compare the cash flow multiples. According to Morningstar, Apple is trading at 25.6x trailing free cash flow compared to Google’s P/FCF of 38.6x. Google’s P/FCF ratio is more than 50% higher than Apple’s, and that’s on a trailing basis. Consider that Apple will probably sell close to as many iPhones in this quarter, as it did in the past year in total. Also, factor in dozens of new countries that the iPhone will soon be offered, as well as increased exposure through Best Buy outlets. iPhone sales are certain to increase free cash flow relative to reported EPS due to the 24 month revenue deferral. As I mentioned in my July analysis, I wouldn't be surprised is Apple could generate more that $10 FCF/shr next fiscal year. Hence, Apple’s free cash flow is poised to increase dramatically. In contrast, Google’s free cash flow growth will likely match EPS growth, if even that. Google’s has high capital spending needs, and even much higher if considering cash spent on acquisitions. A more detailed analysis on the matter will be presented later.

Evaluating P/E multiples: Apple trades at a higher forward P/E- 28.9x vs 20.6x based on expected FY09 EPS. On the surface, this appears to be backwards, since Googles earnings are expected to increase 23% versus Apple’s 16%, it would seem Google should be afforded the higher P/E multiple. Thus, GOOG would appear to be of better value superficially. However, a closer examination reveals that Apple’s multiple isn’t unreasonable, rather uninformative. There are several justifications for Apple’s higher P/E multiple.

First, Apple’s FY09 estimates are most likely too low. Apple has significantly exceeded the consensus estimates for many quarters going back. 16% EPS growth is not inline with Mac sales growth which has been north of 40%. This spills over into hardware and software sales growth which has been growing roughly 30-40% Yr/Yr in recent periods. Music sales has been north of 30%. More iPhones will continue to support that growth. iPod sales have been one area of concern, yet FY08 iPod revenue growth has been stronger than FY07, and with the expected introduction of new iPod models, iPod growth should not significantly falter.

The key issue has been the reduced margin guidance. I believe there are two possibilities: 1) Management is being overly conservative 2) Apple is undertaking a more aggressive strategy. Neither of the two are unfavorable. According to Andy Zaky’s research at Bullish Cross, Apple has a long history of sandbagging on its margin guidance which has enabled Apple to consistently beat EPS numbers. Generally, Apple only exceeds revenue estimates by a slight to moderate margin, yet its EPS continues to come in by a much higher amount. Therefore, it’s very possible that management is being overly conservative. The other possibility is that Apple is actually being candid, but not necessarily a cause for concern. Management alluded to a “new product transition” and I also detected a latent overtone of possibly more competitive pricing. Apple wouldn’t sacrifice margin unless it were to more than offset the ensuing profit reduction with increased sales volume. Why would it? Apple doesn’t have to shrink its margins voluntarily. Historically, it hasn't had to defend market share with price promotion. Thus, Apple may be looking to measurably expand its share with more completive pricing. In short, I don’t expect the lowered margin guidance to negatively impact earnings growth.

Second, FY09 EPS would be significantly higher if Apple didn’t account for iPhone sales using subscription guidelines. This is a key issue many others are missing or just choosing to ignore. Most analysts expect Apple to sell more than 20 million iPhones next year, which may amount to 10 billion in revenue, yet it will be reported over a 2-year period even though resulting cash flow will be received on the front-end. At minimum, under traditional accounting methods, Apple’s FY09 EPS would be at least $1 higher than current estimates. I stress “at least.” That would push Apple’s FY09 growth back above 30%.

Google’s Revenue Demand Outlook:

Google’s main source of revenues is online advertising, notably paid-search. Google dominates as it garners an overwhelming share of search traffic and paid-search ad dollars. Google’s sales growth rate has been decelerating for a couple reasons. First, the “Law of Large Numbers” is beginning to take affect. It’s much easier to increase sales 50% from a revenue base of 1 billion than it is from $10 billion. No growth stock is immune from this inevitable constraint. Second, more importantly, Google is exhausting its growth avenues in paid-search.

The three paths for a firm to increase sales are 1) Market Growth- non-users become new users 2) Increase Market Share- steal current users from competitors. 3) Up-Sell Own Customers- entice current customers to purchase more or pay higher prices. 

Google’s rapid growth has originated from the online advertising industry growth, coupled with market share gains within that industry. Generally, as the industry life cycle evolves, firms initially focus on capturing growth as the market expands and attempt to avoid clashing with other industry participants. When industry growth ebbs, firms then look to take share from weak competitors for sustaining sales growth. When low-hanging fruit has been harvested, a firm may attempt to raise prices if it has monopoly power (differentiated product) which assuages customer defection.

What has been Google’s major focus recently? Raising prices. Customers bid on key search terms providing price formation as PPC, or price per click, the amount an advertiser is charged each time a consumer clicks on the sponsored search result. Google has been working on improving quality, hence relevancy of its paid search ads displayed. The goal is to reduce the “bounce rate” which is when a user clicks an advertised link and subsequently navigates off the destination web page without navigating any deeper on the landing site. The advertiser still incurs charges for the traffic sent to its site, however it didn’t produce any value. In theory, the higher number of clicks leading to a sale should be more valuable, thus command higher prices. If Google’s major effort is enhancing ad search value, what does that imply about its other avenues for growth? It basically confirms what is logically apparent. Internet advertising market growth is decelerating as it traverses the path towards saturation. Google’s market share growth has also been decelerating. Both areas are still growing, albeit, at slower rates. The outlook for market share growth is limited. Google already commands an overwhelming majority giving it less room to expand. It has taken so much of the market there is not much more left to take. There will always be room for niche players that provide value by offering an alternative to Google. Yahoo is moving in that direction as it continues to lose share, joining the likes of Ask, MSN, etc. but will be off limits to Google for anti-trust reasons.

This new focus provides clear evidence that Google can’t solely rely on industry growth and share gains to support continued sales growth. Google also needs to find new growth sources aside from online advertising. This is a primary focus as evidenced by the heavy capital spending, research & development, hiring, and new acquisitions. It’s quite nebulous as to how this will all take shape, yet there’s a very good chance that Google will be the pioneer in new market spaces once they evolve.

There is no question that Google will continue to turnout impressive growth, as it’s the leader in a space that should continue to demonstrate above-average growth. And, there are all the other growth opportunities that Google faces. Given its technological leadership and market position, Google has the advantage going into emerging product spaces. The key question in my mind continues to be “Google’s growth- At what cost?” How much of this capital spending and R&D will pay off? How about acquisitions? Can Google get those to add value, specifically YouTube and DoubleClick? Or, will Google destroy shareholder value from investing in areas that fail to produce desired returns? For me, these are the most pressing issues.

Many say that Google is a one-trick pony, and a pony not getting younger at that. Another characterization is Google is Janus-faced: part cash cow,a piggy-bank that will continue to get fatter, coupled with the side that milks the cash cow in efforts to add to its cattle herd. In order for Google’s stock price to move higher, investors will need to see evidence that Google’s spending and investing activities are worthwhile. I published an analysis of Google on March 18, 2008 when shares were trading below $440. I concluded from my analysis and valuation modeling that Google’s fair value was $537. I think that fair value estimate roughly still remains intact today, yet I haven’t done the needed in-depth analysis to ascribe a high degree of confidence to it. My thinking is I would be a buyer under $500 and a seller above $550, absent of any new developments.

Apple’s Revenue Demand Outlook:

Apple’s Mac computers only account for single digit share of the PC market. That share has been increasing at breakneck speed, and there hasn’t been any indications that the trend won’t continue. With the capability of running Windows OS on Mac hardware, the transition barrier has been drastically reduced. Apple’s small market share provides vast room for sales growth. Same could be said about the iPhone. The iPod business may be approaching a saturation point, as I recently evaluated. , however Apple is likely to introduce new models that may lift growth. There is no telling what new products Apple will come up with. They will likely be natural extensions or complements to existing offerings which will allow Apple to leverage its installed base. This is essentially what we have been witnessing as the “halo” effect. 

Apple has also not appeared to be as economically sensitive as Google. Mobile phones and computers have become daily needs, whereas online advertising is not. When the economy weakens, consumers will not spend as much or as often on phones and computers, yet the first item axed from corporate budgets is advertising spend.

Apple’s demand outlook is strong, and it generates strong free cash flow due to low capital investment needs and working capital. My view is that Apple’s cash flow prospects are not entirely reflected in its share price causing the stock to be undervalued. Considering how little incremental investment is required to support sales growth, Apple is great company. Assets such as brand equity and human capital aren't reflected on the balance sheet, yet those are critical value-generating assets. With the additional cash flow I expect the iPhone to deliver next year, I believe AAPL will surpass $250 in 2009.

Profit Margins:

Another difference many point out is profit margins. Google has higher net margins than Apple 25% vs 15% (ttm), yet there is a major caveat that shouldn’t be ignored. Net income reported is not the amount of cash that is available to shareholders. Free cash flow is, since it’s net of capital expenditures and other investments using internal cash. The FCF margin (FCF/Sales) is roughly identical for both firms, about 20% in the trailing 12 months. Google’s capex as a percentage of sales is much higher than Apple’s. Additionally, Google has spent large sums of cash on acquisitions recently which I didn't include in the FCF margin calculation reported above. In the last 12 months, Google spent over $4 billion acquiring businesses, or 20.5% of total sales. In FY06, cash acquisitions were 3.8% of sales, and 5.5% for FY07. Therefore, Google may have a higher net margin, yet it must spend heavily on capital assets and acquisitions which results in less remaining cash that could be distributed to shareholders.

Another notable fact: Apple’s net margin has risen from 10.3% FY06, to 14.6% FY07, and is 14.9% in the last four quarters. Google’s net margin has declined, 29% FY06 to 25.3% FY07, and to 24.6% in the trailing four periods.

Capital Investment Requirements:

Apple’s capital expenditures were 2.9% of revenues for the last 12 months according to Morningstar. This has been drifting lower as capex/revenues was 3.4% in FY06, and 3.1% in FY07. Google’s capex requirements are significantly higher as it has averaged north of 14% of revenues for the past year. As mentioned previously, Google has also used cash to acquire businesses which pushes cash investments as percentage of sales above 20%, to be exact 35% for the preceding 12 months. This illuminates the stark difference between Apple and Google many fail to consider.

Operating Expenditures:

Google spends heavily on research and development as evidenced by 12.9% of sales in last 12 months. This has ticked up from 12.8% in FY07 and 11.6% in FY06. Apple’s R&D is much more modest, 3.3% TTM, 3.3% FY07, 3.7% FY06. Google spends nearly 4x as % revenues than Apple, and Google’s R&D has been increasing while Apple’s R&D has been falling/stabilizing

Apple’s selling,general, and administrative expense (SG&A), the technical word for overhead, has been falling as a percentage of overall sales. In contrast, Google’s SG&A expense is higher (%sales) and has been trending in the opposite direction, up. This can partially be attributed to the massive increase in Google’s head count as well as additions to its sales function. The idea behind an internet company is that there are economies of scale, incremental revenue dollars incur lower costs, not higher costs, as sales are spread over fixed cost base. This hasn’t proved to be the case with Google, nor Amazon for that matter. Yet, the caveat is that these two have experienced rapid growth, and are spending in attempts to generate more.

Since Apple’s product categories/markets are more defined, it’s able to spend at a more measured pace to support growth. Being of a more traditional business model, Apple is able to spread overhead expense over higher sales volumes, in effect leveraging its cost structure to boost margins.


Google spends heavily on capex, acquisitions, R&D, and new hires in attempts to sustain its robust growth. Google’s paid-search business probably won’t be able to sustain above 30% revenue growth for too much longer. It’s likely that growth will gradually fall into the upper to mid-teens where it will stabilize. Google is positioned to capitalize on an immense number of growth opportunities as they are presented. It’s in the driver seat, yet there is some risk Google may spend frivolously on efforts that never come to fruition. Yet, there’s also the potential of huge rewards that cold result from Google’s heavy investing translating into a market leader in new spaces. Google’s new sources or growth are not entirely clear at the moment, opposed to Apple’s growth sources being more defined.

Apple has plenty of room for growth due to its low share of PC and mobile handset market. Apple has built substantial momentum in capturing more share in both markets. Apple has low R&D and capital spending requirements, Margins have been improving, as the desired effects of scale and operating leverage come into play.

Google’s margins are falling as expenses increase, the opposite effects of leverage. This implies that there is an increasing incremental cost of generating an additional dollar of revenue. Thus, in my mind, this suggest Google is hitting headwinds as it has picked the low-hanging fruit.

Apple and Google can’t be compared on a P/E basis because of the differences of accounting treatment and capital spending which affects free cash flow. Reported income doesn’t accurately present either firms real story. To better assess and compare Apple and Google, one must examine each firm’s cash earnings, thus P/FCF is a much more suitable metric for comparison.

Disclosure: None

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